Payroll tax withholding refers to an employer retaining part of an employee’s salary. The withheld amount is paid as tax directly to the IRS or other appropriate organization, like the Social Security Administration. Withholding allows the employee to pay a portion of their taxes every month from each paycheck either manually by the employer or through payroll tax withholding software. Doing this reduces the lump sum that the employee might have to pay when they file their annual tax returns.
The amount withheld is based on the employee’s income and other details, like exemptions, marital status and dependents. If the total amount withheld for the year is more than what the employee would have had to pay on their annual tax returns, the employee will get a tax refund.
Who Requires Payroll Tax Withholding?
The IRS typically requires withholding for federal taxes, and employees will likely be subject to state, local and school taxes. The Social Security Administration also requires withholding from an employee’s income. Social Security helps the employee after their retirement and provides a paycheck of sorts after they reach a certain age.
Another payroll tax withholding is for the Medicare program. This money, along with Social Security withholdings, is called Federal Insurance Contributions Act (FICA) taxes. Both the employer and the employee have to contribute to FICA taxes. Since all withholdings are made by the employer, the employee has no need to pay any of these taxes or fees directly. The employer must make sure that the payments are made on a regular basis so that they do not incur a penalty. This can be achieved through either a manual payroll process, or by using payroll tax withholding software.
Payroll Tax Withholding Exemptions
Employees can claim applicable exemptions to reduce the amount of taxes withheld from their paycheck. The number of exemptions increases if the number of dependents increases or if one spouse loses their job. However, taking too many exemptions may not always be a wise choice. In the end, the amount of tax due at the end of the year may be more than what was withheld because the exemptions lowered their monthly withholdings too much. In that case, they will owe the IRS money. Conversely, if more money was withheld than the employee owed, they can receive a tax refund.
Employees who want to make federal income tax withholding adjustments do so on Form W-4, which they should get from their employer.
At the end of the year, employers should give a W-2 to all of their employees. The W-2 will list an employee’s total income as well as the total tax withholdings for the year.
Exceptions to the Rule
Contractors and freelancers do not have payroll taxes withheld throughout the year. They have to pay all of their taxes when they file their annual tax returns, unless they make quarterly estimated payments throughout the year. This can leave freelancers in a tough situation come tax season. Anyone who receives a 1099-MISC form instead of a W-2 needs to pay all federal, state and local taxes on their income. This includes paying both parts of the Social Security tax. Normally the employer would pay half of the Social Security tax, but since there is not an employer, the contractor must assume responsibility the whole payment.
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